by Calculated Risk on 1/06/2006 08:19:00 PM

Here is another Fed Watch from Dr. Duy: A Little Something for Everyone. Duy mostly looks at the employment report, but he also writes:

Wall Street's stamp of approval implies a wide expectation of "one and done" for this tightening cycle. That's not quite my interpretation, although I can't blame traders for looking for good news after a dreary December. Instead, I left the minutes with the sense that another rate hike at the end of the month is in the bag, but beyond that, future changes in policy are not automatic but instead data dependent. That is decidedly not the same thing as "done."

Barring some drastic change in the data, I think two more rate hikes are "in the bag" and we will see 4.75% at the March meeting.

As a note: Dr. Duy's Fed Watch is a regular column on Economist's View. For weekly updates on market expectations for the Fed Funds rate, see Dr. Altig's Macroblog.

The reason I think the Fed will raise rates at least two more times is because: 1)the data will probably be inconclusive and 2) Dr. Bernanke has been heavily criticized (I think unfairly) for being an inflation dove based on this speech: Deflation: Making Sure "It" Doesn't Happen Here and, therefore, if the Fed pauses at Bernanke's first meeting in March that would inflame the criticism. So I believe Bernanke will lean towards one more hike to prove his inflation fighting credentials.


Click on graph for larger image.

Using the Cleveland Fed Median CPI, this graph shows the real Fed Funds rate by quarter for the last five years - the period of emergency interest rates.

I think the Fed would like to see inflation below 2% - median CPI was 2.6% annualized last month and 2.4% over the last 12 months. To achieve their goal, the Fed will probably have to raise the real Fed rate to 2% to 2.5% and that puts the nominal Fed Funds rate at 4.75% or even 5%.

After the January hike, the key data will be the various measures of inflation. If inflation is subsiding, then the Fed might stop. If its close, I expect another hike in March.

When will the Fed cut rates?

I've written several times that I expect a rate cut later this year. The reason I expect a cut is because of the impact of a housing slowdown. If there is no housing slowdown, as predicted by Wells Fargo, then I doubt we will see a rate cut in 2006. If there is a slowdown, I expect two things: 1) Mortgage equity withdrawal to decrease significantly and impact consumer spending (like what happened in England) and 2) housing related employment to fall.

The Fed doesn't like to change directions too quickly. Looking at the Fed's recent history:

Rates peaked at 6.5% on May 16, 2000 and the first rate cut was almost 9 months later, in January 2001.

Rates peaked at 6% on Feb 1, 1995 and the first cut was 5 months later in July.

And speaking of England, the Bank of England repo rate peaked in August 2004 at 4.75% and the BOE cut the rate to 4.5% one year later.

So, if housing slows down, I expect a rate cut in late 2006.